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Correction to This Article
In the Dec. 11 Real Estate section, the Housing Counsel column included an incorrect date by which a questioner would have to sell his house to qualify for a federal capital gains tax exclusion. The law requires that a homeowner live in a house for two of the preceding five years to qualify for the exclusion. In the case discussed in the column, the owner would have had to sell the house by Dec. 31, 2003, to qualify, not Dec. 31, 2004.

We bought our house in the 1960s for about $35,000, and have put in about $50,000 of improvements. We lived there until Dec. 31, 2000, when we retired and moved to the South. Since then, we have rented out the house and received a nice rental income. The house is now worth almost $800,000 and we understand that if we do not sell the house before the end of this year, we will have to pay a lot of capital gains tax. Unfortunately, we do not believe that we can sell our house that quickly, especially since the tenant has several more months to go on the lease. Is there any way that we can avoid paying the capital gains tax?

Let's explain the law first. Because you are married and presumably filing a joint tax return, if you have lived in the house for two out of the previous five years before it is sold, you can exclude up to $500,000 of any profit you have made. (If you file a single tax return, the exclusion is limited to $250,000.) Because you moved out on the last day of December 2000 and lived there two years before that date, you must sell your house by December 2004, in order to take advantage of this significant tax saving.

Otherwise, your tax liability will be huge. Your basis for tax purposes is $85,000 ($35,000 plus $50,000). If you sell the property for $800,000, excluding real estate commissions and closing costs, your gain will be $715,000. At the current 15 percent tax rate, you will have to pay Uncle Sam $107,250, plus any applicable state or local income tax. Additionally, I suspect that you have taken depreciation on the house since you first started renting it. You should discuss with your tax advisers whether you will have to recapture any of this depreciation.

On the other hand, if you can sell before the two-out-of-five-year period ends, $500,000 of the gain will be excluded from tax, and you will have to pay federal tax on only $215,000 of profit -- or $32,250. That's still a lot of tax to pay, but clearly much less than if you cannot take the exclusion.

Thus, I would try to market the property immediately, even if you have to sell it for somewhat less than its market value. What you may lose by way of sale will more than be made up by the capital gains tax savings. Talk with your tenants. They may be interested in buying.

There is another approach that you may want to consider. However, a strong word of caution is in order: The approach outlined below has not been approved or authorized by the IRS.

Before 1997, when Congress enacted the Tax Reform Act authorizing up to $500,000 exclusion of gain, homeowners were subject to what was known as the "rollover." Under this approach, if you sold your principal residence and bought another property within two years before or after the date of sale, you were able to defer any gain made on the sale. The gain was deducted from the sales price of the new house, so your tax basis was lowered.

Example: You bought property for $35,000 and put in $50,000 worth of improvements. You sold the property for $300,000 and within two years had bought another property worth at least $300,000. Although the new price was $300,000, because you had made a profit of $215,000 ($300,000 minus $85,000), this profit was "rolled over" to the new house. Accordingly, the basis for tax purposes of the new $300,000 was only $85,000. The tax theory for this was simple: You did not avoid tax, but only deferred it to a time when you ultimately sold your house. Then, assuming there were no other tax-saving devices available, such as the once-in-a-lifetime exclusion of $125,000 when you reached age 55, you would have to pay all of the gain you made on all houses. (Note that the rollover and the once-in-a-lifetime exclusion are no longer in effect; they were repealed in 1997.)

However, many people found that although they bought a new house, they were unable to sell their old one within the two-year period.

What did they do? They created a Subchapter S corporation and sold the property to their corporation for the full market price. This way, they deferred the tax on the sale, and when the Subchapter S ultimately sold the property, its gain was relatively small.